It’s scary to start the month not knowing if you can pay your bills. This fear is compounded when one of those potentially unpaid bills includes your mortgage.
The recent COVID-19 outbreak and the subsequent job losses only helped to fuel the fear around mortgage defaults — thing is, missing a monthly mortgage payment doesn’t immediately set-off a catastrophic chain of events leading to you eventually becoming homeless). However, missing a mortgage payment can have a long-term impact on your credit score.
To help you understand what’s at stake, we walk through the broad steps on the mortgage default insurance fees you pay (and who they protect), what happens if you miss a mortgage payment, along with some proactive tips on how to avoid mortgage default (and why these tips are really, really important).
What are mortgage default fees?
We’ve all read how important it is to save up 20% as a down payment on the purchase of a home, but for many first-time buyers, this goal is either not possible or not ideal.
There are advantages to not putting 20% down on the purchase of a home (read more: Why you don’t need a 20% down payment), as well as disadvantages. One big disadvantage is that you’ll have to pay mortgage default insurance fees.
Why? By law, any property purchased with less than 20% of a buyer’s own money, must have mortgage default insurance. While the premiums (known as ‘fees’) for this insurance are paid by the home buyer, the beneficiary is the lender. Should a homeowner default on their mortgage and the loan is not repaid to the lender, this insurance covers that loss.
Mortgage default insurance, which is commonly referred to as CMHC insurance, is mandatory in Canada for down payments between 5% (the minimum in Canada) and 19.99%. These fees are calculated based on a sliding scale — the more of their own money a buyer spends on buying a property, the less the home buyer pays in mortgage default fees. (Fees range between 2.8% and 4% and are based on the total mortgage debt to be borrowed.)
Why do lenders need mortgage default insurance?
Although mortgage default insurance fees can add thousands and even tens of thousands to the cost of a home purchase it allows homebuyers who may otherwise not be able to purchase a property to get into the Canadian real estate market. Without these fees (and the insurance), mortgage rates would actually be much higher for all home buyers, as lenders would have to price in the risk of mortgage defaults. However, the insurance provided by these fees allows lenders to offer lower mortgage rates — so much so, that sometimes the best rates can only be obtained if a buyer chooses to pay less than 20% as a down payment on a home (because the risk of default is passed along to the mortgage insurer). For more, please read: Why you don’t need a 20% down payment
What is a mortgage default?
For most people, the term mortgage default is synonymous with the act of not making your mortgage payment. In reality, however, mortgage default is a legal term for any situation where you are in violation of your mortgage agreement.
A mortgage agreement is the thick stack of papers you signed when you first got your mortgage. This stack of papers is a contract; it sets out what you get from the lender and what you are responsible to do, as a borrower, in order to keep the contract in good standing.
In truth, there are seven ways to default on your mortgage:
#1: You missed making mortgage payments
The most obvious form of mortgage default is when you miss a payment or two to your lender.
Under your mortgage agreement, you are legally obligated to make payments at regular times, as outlined in the agreement you signed with your lender.
Most lenders will not start a legal default process if you miss one or even two mortgage payments, however, if there is a pattern of missed payments or you simply stop making payments altogether, the lender has the right to start legal proceedings to take ownership of your home. This process is known as a foreclosure and can result in a short sale or a power of sale process, where a property is temporarily under the ownership of the lender, before being sold (and the proceeds of the sale are used to pay off the outstanding mortgage debt).
#2: You don’t have home insurance
Most mortgage lenders legally require home buyers to purchase homeowner’s insurance.
These insurance policies protect you, the homeowner, from having to pay out of pocket for damage or destruction to your home.
So, why would a lender care if you have insurance? Because lenders realize that most people who buy a home using a mortgage don’t have a surplus of cash that can be used to cover large outstanding debts, like a mortgage, should the property be severely damaged or destroyed. By requiring a homeowner to keep valid home insurance, a lender is confirming there will be money available to pay off the outstanding loan — through insurance proceeds — in the event the property is severely damaged or destroyed.
#3: Failure to pay property taxes
If you fail to pay your property taxes, you could find yourself in default on your mortgage agreement.
How? Because local municipalities will use different methods to collect unpaid property tax money. At first, your local government will add interest and penalties to the amount you owe, in an effort to motivate you to pay up the outstanding amount owed. If that doesn’t work, the city will register a tax lien on your home. Like most liens, a tax lien (or tax arrears certificate) will prevent the sale of a home or require the new buyer to assume the outstanding debt and pay it off before taking legal ownership of the home.
Lenders do not like being confronted with properties with tax liens since these legal claims to any asset (that can be used to pay the debt) take priority over all other liens secured by your home, including your mortgage. As you can imagine, lenders don’t like being told that their loan is second in line to being paid and, as a result, may result in taking legal action to take ownership of the property in an effort to sell and pay off the outstanding mortgage (and, in this case, tax) debt.
#4: Take out a second (secret) mortgage
As the name applies, a second mortgage is a debt that uses your home’s equity and is second-in-line for repayment. Much like the first mortgage, a second mortgage uses the equity in your home as collateral, allowing you to access 90% to 95% of your home’s current market value (or the value the lender’s appraiser gives your property at the time of application).
There are many types of second mortgages from standard mortgages, with terms and fixed rates, to Home Equity Lines of Credit, to private-lender loans with higher rates.
While second mortgages, also known as piggy-back loans, are common, these loans can only be legally obtained if both the first lender and the second lender are aware of their claims on the underlying asset, your home. Also, the lender of the second mortgage can also initiate foreclosure proceedings even if the homeowner is not behind in their first-mortgage payments.
#5: Undertaking extensive renovations without the lender’s consent
Another way to find yourself in mortgage default is to undertake major renovations or a big remodel without first clearing these home reno plans with your mortgage lender.
While it is rare, lenders have the right to initiate foreclosure proceedings if a homeowner decides to undertake major renovations (or tear down and rebuilt a home) without first notifying the lender. The reason is the lenders provide the mortgage loan based on the current home’s value. Even if the renovation will significantly improve the market value of the property, while the property is undergoing these renovations, it could be hard for the lender to sell the property, should you stop making mortgage payments and default on the loan.
Now, if you were to tear down the house, with the aim to rebuild another property, and didn’t tell your lender, you could be inviting the lender to start the default process. That’s because tearing down a home, even if your aim is to rebuild, is essentially turning the property from a single-family home to land — which seriously reduces the overall value of that property, at least for the short-term.
#6: Failing to adequately maintain your property
Believe it or not, homeowners can also find themselves in mortgage default if they fail to maintain their property (or rent out any part of their property, or change the zoning or use of the property).
Again, lenders provide mortgages based on the current use of the property, and the current use of a property helps dictate its market value. Changing the use or failing to maintain the property can help decrease a property’s value, and this can threaten a lender’s risk portfolio. Basically, anything that negatively impacts the value of the property can be a cause for default.
While it’s rare for a lender to pursue legal action based on these reasons, it is possible.
#7: Selling the property without the lender’s consent
While this rarely happens — as most sellers are required to obtain documentation from their current lender in order to legally sell a property — this situation can arise if the property is transferred from one family member to another.
Quite often the owner of a property will change the name on the official mortgage document as a way of protecting the asset from creditors — particularly if the current property owner anticipates running into money problems.
But do this without telling your mortgage lender and you could find yourself in mortgage default. That’s because most mortgage agreements will have a clause that does not allow you to transfer ownership of the property without either paying off the mortgage or getting the lender’s formal consent.
Since this action is often taken in ignorance of the potential results, some lenders will give the initial owner a three- or four-day window to transfer the property back into their names; others are not as sympathetic and will ‘call the loan’ — demand full payment of the outstanding debt.
In sum, doing extensive renovations, renting out a basement, falling behind on property taxes, letting an insurance policy lapse or transferring ownership, along with not paying your mortgage, are all fairly common scenarios that can trigger a mortgage default.